Problem of NPLs in financial institutions

Alex Tawanda Magaisa

ONE of the key obstacles that negatively affect dynamism and growth in the financial sector is the problem of non-performing loans (NPLs).



rial, Helvetica, sans-serif”>At the basic level, NPLs are bad loans resulting from poor investment policies and practices by the bank. Whilst technical definitions vary, more elaborately, they are loans that have failed to comply with the original terms of the loan agreement.


A loan becomes impaired when the borrower’s assets are locked up and there are inadequate means to pay the loan when it becomes due. The criteria for judging whether a loan has become non-performing vary from one country to another. This article seeks to highlight the problem of NPLs within the Zimbabwean banking context and advises that it is necessary to confront the problem directly and quickly rather than postpone it until the difficulties become insurmountable. In my view, due to the current pressures on banks to meet minimum capital requirements, there is always a good chance that most banks will continue to carry NPLs to shore up their balance sheets.


Several countries across the world have at some point faced the debilitating effects of NPLs in the financial sectors. These include the USA in the 1980s and more currently, the Far East and South East Asian countries such as Japan, China, Thailand and South Korea.


There are diverse reasons for the existence of NPLs. At the basic level, NPLs represent investment failures which can affect any credit industry. In the credit industry there is always the risk that some debtors will find it hard to pay for various reasons. Nonetheless, when the level of NPLs balloons beyond reasonable standards, it becomes a problem that goes beyond the normal risks involved in lending. They may arise because of reckless lending policies which often take place during a period of economic boom when financial institutions have excess capital and liquidity. When the bubble bursts, as it did in Japan in the 1990s, the borrowers can find themselves in a position where they are unable to pay back the loans.


The existence of poor corporate governance techniques is also at the centre of the problem of NPLs. The companies that lack proper risk management techniques and discipline fail to implement discipline in their lending policies resulting in, among other things, insider loans and bad lending decisions based on inaccurate and ill-considered bases.


There may also be external factors such as political decisions that negatively affect the economy leading to the emergence of bankrupt borrowers who would under normal circumstances be good debtors to the banks. Therefore, political policies that impair property rights in real estate which is often used as collateral has the effect of transforming good loans into non-performing assets. The lack of coordination with and stability within the real estate industry leading to inaccurate or unstable evaluations of collateral also affect the stability of the credit market resulting in bad loans when the asset values plummet. All too often however, failure to acknowledge and deal with the problem due to hesitancy by the financial authorities leads to a build-up of a large portfolio of NPLs within the industry.

NPLs have a negative impact on the individual institutions and economy as a whole. The retention of large portfolios of NPLs places a burden on economic growth and causes stagnation in the market. It incapacitates lenders who eventually fail to advance credit to small and medium-scale businesses while they also fail to generate cash for the provision of interest to depositors.


The existence of NPLs also causes systemic risks within the banking industry since it debilitates the liquidity of institutions. Since NPLs remain on the balance sheet, they create a façade that does not reflect the true financial health of the bank in the long-run. It has also been argued that the retention of NPLs also causes negative pressure on the valuation of securities (eg shares) of lending institutions.


The problems arising have led some analysts to argue that it is necessary to decisively deal with and dispose of NPLs. On the other hand, there is hesitancy to dispose of NPLs among both the institutions and the regulatory authorities. Loans are represented on the balance sheets as assets belonging to the banks. Even when a loan has become non-performing, it may be kept on the balance sheet in the hope that recovery of the economy will enable borrowers to pay back.


The disposal of NPLs causes a shift in the balance sheet which may affect the position of the company especially when it is unable to mobilise alternative capital. This is especially the case in banks which are required by law to keep a minimum level of capital. The disruption in the capital base without alternative sources of capital may lead to liquidations and bank collapses which in turn cause unemployment and instability in the financial system. The state is often unwilling to accept this given the political pressure that it attracts. Consequently, the state may push institutions to understate the level of NPLs and postpone the problem in the hope of an economic turnaround. Meanwhile, the problem is only prolonged and the NPL portfolio may even increase to levels that may be difficult to manage.


Thus the desire to avoid deficit in the balance sheet and the failure to mobilise fresh capital leads banks to keep NPLs. Ideally, lenders must provide adequate capital reserves to cover NPLs which may result in losses. However, in many cases the reserves kept may be low. In addition to the failure to mobilise capital, lenders may provide low cover for at least two reasons – deliberate provision of insufficient reserves and lack of knowledge of the adequate reserves.


The deliberate provision may result from the way they classify NPLs such that sub-standard loans can be classified as good loans. The amount of reserves to cover losses resulting from the disposal of loans depends on the categories into which the NPLs are classified eg substandard, doubtful and loss.


The lack of knowledge of the adequacy of the reserves results from poor systems of credit risk management, which is a matter of corporate governance. It is therefore necessary to improve the technology for risk management in the industry and the emphasis by the Reserve Bank governor in his Quarterly Report in June is to be commended.


In addition, an ethical problem arises when dividends and executive windfalls are paid when the company has a huge portfolio of NPLs. This is especially the case where the failure to dispose of, or provide adequate cover for NPLs is a result of deliberate management actions. The failure to dispose of NPLs while paying huge dividends and executive windfalls is not right.


A Japanese researcher, Takahaishi argues that where there are such deliberate actions, they ought to be found criminally liable in order to exert pressure on management and also expel them from the system in order to clean up the sector of wanton elements. However, in the case of poor risk management techniques, the authorities must implement and enforce proper corporate governance standards and utilise better technology in financial management.


Besides improving investment and credit management techniques within the sector, other initiatives must come from the government. First, authorities must recognise the problem and devise ways of dealing with it. There is a growing market in the securitisation of NPLs in most industrialised and emerging markets.


Investors are buying NPLs from banks and other institutions for purposes of securitisation. This is a complex financial markets technique which partially or wholly frees lending institutions of the portfolio of NPLs. The question is whether the market for the sale of NPLs exists in small economies such as Zimbabwe.


Whatever the case, securitisation is proving to be a key technique in tackling the NPL problem across the world. The question is whether the emerging asset managers in Zimbabwe are ready and willing to play a part in this game. In other countries such as Korea and Japan, the state intervened directly by setting up asset management companies to buy NPLs from institutions for securitisation while in France and Italy, governments chip in by providing guarantees. Securitisation has several benefits to the banks selling them.


Firstly, it frees up funds placed as reserves for the loans and thus reduces the banks’ regulatory capital requirements. Banks are also able to get an additional source of cheaper funding through this method. Like any investment technique, securitisation carries its own risks. The key is to ensure that it’s properly carried out. The expertise and experience may also be lacking in emerging markets but technical assistance can always be imported. Additionally, banks could send staff for training and familiarisation tours in the major markets and the state could also help in that process. In the end, it rests with whether the state has the necessary political will to recognise the problem of NPLs and the commitment to deal with it without further ado.